Friday, May 23, 2008


Investors who prefer stability in their portfolios and are not comfortable with stock market volatility can look at dividend yield stocks as an alternative to debt based instruments.

Suppose a stock with a face value of Rs.10 is quoting at Rs.100 and giving a dividend of 50% currently i.e. Rs.5 per share of face value Rs.10, then its dividend yield is 5 %. An investor in this stock receives Rs.5 by way of dividend, on every Rs.100 invested. At present dividends are tax free in India which makes it all the more attractive.

Now one might argue that 5 % is low as compared to 8 to 9 % returns available on debt instruments. But one needs to take into account the potential for capital appreciation, that is most likely to accrue over the long run, if the stock has been carefully selected to begin with.

Consider a business with a dividend yield of 5 %. Now take a simplistic scenario where this company is growing its profits at a steady 15 % per annum, year after year. It also keeps on increasing its dividend at the same rate. Now also assume that the market discounts the earnings of the company also at the same rate as on the date of investment. What would happen after 5 years? Growing at 15 % per annum, the profits of the company would double and its dividend will be now raised to twice the original. The initial investors who had got in at 5 % dividend yield would now find themselves earning dividends at 10 % of their principal invested.

Not only that, since the earnings have doubled, the market would now value his company at twice the original price. Therefore our investor stands to gain both ways. One, he is now getting dividends at more than the market rate for debt instruments and two, his original investment has appreciated by 100 %.

An added advantage of such stocks is that their dividend yield protects their market price from falling very much. For instance if the market price of a company with an initial dividend yield of 5 % fall by half, the new dividend yield now becomes 10% based on the current market price. This makes the stock attractive for many investors to buy, thus pushing the price upwards.

A caveat in this strategy being, that companies are not obliged to pay dividends. This entirely depends upon the business environment. If the company encounters a business slump, this strategy might fail. But the strategy is not designed to protect against adverse business conditions in the first place. It is designed to give stability to a portfolio in periods of stock market gyrations, with the basic fundamental attributes of the business staying intact.

Even this risk might be mitigated to an extent by selecting companies which have a consistent history of steadily increasing dividends over long periods of time. Several multinationals and PSU banks fit into this category. Another plus in selecting such companies is that, the very nature of their being profitable over many business cycles gives the investor added conviction in their business models.

This strategy can be used to invest a portion of their assets into equity by conservative investors while investing the balance into debt instruments. It may not give mind blowing returns but will impart a solidity to the investor’s portfolio with returns that at least beat inflation, while ensuring a good nights sleep.

1 comment:


Well selected dividend stocks can bring great rewards.